Nilesh Shah is highly bullish on two sectors. Here’s why

Capital goods as well as manufacturing companies should have good runs going forward. Obviously, it will not be a straight run, there will be disappointments as well on the road but overall banking and capital goods should reward investors, says Nilesh Shah, MD, Kotak AMC. Edited excerpts:

We have seen a decent pullback in July. How should one approach the market from here on?
Right now, the market is clearly processing data. When commodity prices including crude went up, the valuations were little ahead of their fundamentals. Market was optimistic and correction happened. Then another extreme event happened where markets corrected. They fell little below their fundamentals but not by much and then suddenly commodity prices corrected. Crude has not corrected as much as we would have loved so clearly markets will be driven by how the event shapes up.

There are four key events which will continue to influence the market - the evolving geopolitical scenario with the US, Ukraine and Russia coming together. The second will be oil prices and especially European winter and gas prices. The third will be the inflation debate. Clearly it looks like the commodity prices are coming down, inflation is on its way down. And the final thing will be US recession and what Fed does. Does it raise interest rates and then cut suddenly or does it tolerate little higher inflation to ward off recession.

These four factors will continue to influence the market on a top down basis and as a fund manager you have to pick stocks on a bottoms up basis which will be able to overcome these four factors.

We have also seen that markets have punished some of the high value names or high valuation names which were earlier trading on probably price to sales where EBIT margins were very low or losses were pretty high. Seeing a decent amount of correction whenever there will be a risk aversion such sort of themes would tend to underperform and this is no different. Isn’t it?
When you are in doubt, you always want to go back to safety. Despite weak US economic fundamentals, the safe trade is to go to dollar and we have seen dollar index at nearly all time high levels. The same thing applies in equity market. You want safety and profitability, cash flow and dividend yield when there is risk aversion and we have seen high valuation stocks not only across in new-age companies but also in consumer staples and FMCG underperforming the market. Now obviously risk is a cyclical thing, there are times when you are risk averse, there are times when you want to take risk so again as I mentioned this is the market for bottom up stock picking, keep your diversified portfolio you never know how things will shape up in future. Keep some dry powder for buying on correction, we have weathered the storm quite well but it does not mean that we are out of the storm. Yesterday, it was very nice to see one chart where India was right at the bottom with the score zero, this was the Bloomberg analysis on expectation of recession in an economy and we were right there at the bottom so clearly we are far better off compared to the rest of the world but we still have to be careful about how events shape up.

The earnings season so far gave a lot of opportunities. Look at IT, we saw TCS below Rs 300 a share, HCL Tech, Wipro, TCS all falling to 52-week lows. We saw what happened with Reliance, how the street estimates were missed by the conglomerate. We are of course now in the second leg, we have also seen numbers from FMCG counters the earnings so far. What do you make of it?
We have seen earnings in line with expectations, barring few of the counters which you have mentioned. If we agree with the entire earnings, it is little below expectations but it is driven more by the IT and the oil and gas sectors where there are some misses. If we look at the cement sector, PAT drop is lower than what was priced by the market.

If we look at banking sector earnings growth is ahead of market expectation. If you look at bellwether stocks in FMCG sector despite inflation impacting margin, earnings have come ahead of expectations so bearing few large counters which have much much higher weightage on earnings so overall results so far which has come is either ahead of expectations or in line with expectations but do remember that good results generally come in the first half and the bad results tend to bunched up together in the second half.

So our feeling is that June 2022 quarterly earnings will be little below market expectations, it will be driven by inflation hitting the margin. However, what is more critical is the guidance going forward and surprisingly despite all the uncertainty companies are giving reasonably positive guidance. Even in IT stocks where the margins have been hit the guidance has been marginally revised upwards so overall the earnings will be below market expectation on an aggregate and the guidance will hopefully support the market at lower levels.

If I read between the lines, what you are expecting is banks to outperform. Have I got that right? Should capital goods fit in because the two of them do tie in together, the infrastructure story?
These are the two sectors where we are bullish. In the case of banks, NPAs are at decadal low level, NPAs are reasonably well provided for. As interest rates have gone up margins will expand and as the policy rate normalises the treasury losses can be reversed or even if it is now reversed the mark to market notional losses will get converted into income. And more importantly over the last three years most of the banks have underperformed the market so reasonable valuations, expanding NIMs, fully provided NPAs put together it is no-brainer that financial services stocks especially private sector banks and certain PSU banks will be market outperformers.

The second theme that we are bullish on aggregate is manufacturing, thanks to China plus one we have seen some traction in sectors like electrical, electronic components, mobile phone handset manufacturing we believe as capacity utilisation has gone back to 75 per cent plus level many companies have started revising their investment plans.

Capital goods companies over the last four, five years had virtually very-very limited business so they have cut costs, they are fighting fit and now as order flow happens both from the local market as well as global markets they should be in a position to have operating leverage, earnings growth in capital goods sector from here onwards looks fairly fabulous.

I believe there will be some opportunity as energy prices make European manufacturing uncompetitive, it might be temporary in nature but it can be one more catalyst to shift manufacturing base out of China, out of Europe into India. Put all these things together we believe capital goods as well as manufacturing companies should have good runs going forward. Obviously, it will not be a straight run, there will be disappointments as well on the road but overall banking and capital goods should reward investors.

Considering you track the macros with a magnifying glass, where is the currency weakness tied into the entire equation and is that what is keeping the FII fraternity away barring what we have seen in the last 10 days?
In my interactions with the FPIs, I have rarely seen anyone bothered about currency because there will be certain FPIs who may be trading oriented, hedge fund oriented and for them currency makes a lot of difference but for most other FPIs which are majority in India they are long term investors, they are not investing with one month, two-month, three-month view, they are here with three year, five year, seven year view.

Now if you are taking rupee position you are pricing in rupee depreciation based on the inflation differential and productivity differential. So yes, the weakening of the rupee could have an impact on the trading oriented FPI flows but that is very-very marginal.

The long term FPIs will not be really looking at it with too much of seriousness. Number two, as the rupee has weakened in dollar terms it has also appreciated against Yen, Euro and GBP.

A lot of FPIs do come from the US and dollar countries, but there is a reasonable portion in other European and Japanese currency as well. The third thing is that the rupee has to remain near its real effective exchange rate, if it is undervalued it could again deter FPIs, if it is overvalued again it can deter FPIs.

So as long as we are trading nearer to real effective exchange rate I do not think so it is going to have an impact on FPI flows and we have started now seeing that after massive selling from October 21 till now there is some amount of eagerness coming to invest in India growth, we are the fastest growing major economy in the world in 2021 as well as 2022, earnings growth has been fairly decent with little bit weakening of rupee we have become more attractive in dollar terms though not necessarily in GBP, Yen and Euro terms. And despite FPI selling it has been absorbed by the local investors including mutual funds and insurance companies.

My feeling is that if we get a little bit lucky on MSCI where Korea gets upgraded to developed markets from emerging markets, if HDFC Bank, LIC kind of companies get included in MSCI then our weightage in MSCI goes up and that will induce fair amount of FPI buying into the country.